EU Takes A Step Forward
The EU Summit last week ended with the leaders making limited progress in three key areas. First there is now a clear intention to use the Eurozone’s bailout facilities to buy sovereign bonds in the secondary market. This feature was already incorporated into the design of both the EFSF and the ESM, but a political decision was needed to activate it. We do not expect any imminent purchases however – conditionality remains a bone of contention and further details are not expected until the meeting of Eurozone finance ministers on July 9. In the meantime the ECB retains the right to buy sovereign bonds via its Securities Markets Program, although this program has been dormant for months and we do not expect it to be reactivated in the near future. Second, the news that funds for Spain’s banking sector bail-out will come from the EFSF and not the ESM means that these loans will not be considered explicitly senior to government bonds issued by Madrid. This goes some way towards addressing concerns about the automatic subordination of private sector bondholders which could have led to forced selling or even a CDS event. Third, as a long term ambition, EU Leaders have expressed the desire to allow the ESM to recapitalize banks directly, but this would only happen after “an effective single supervisory mechanism is established, involving the ECB”. The process of setting up such a regulatory regime is likely to last at least a year, and perhaps much longer, and therefore this innovation will most likely come far too late to prevent Spain’s sovereign debt levels increasing substantially as European funding is used to recapitalize Spanish banks over the coming months. All told then, while Friday’s developments have bought some time for the euro, the bearish case for the currency remains very much intact, and we reiterate our 1m and 3m targets for EURUSD at 1.24 and 1.20 respectively. Friday also saw both houses of the German parliament approving the ESM treaty and the fiscal compact. The legislation now awaits the approval of the German President who is not likely to sign it into law until Germany’s constitutional court has an opportunity to rule on the matter. Elsewhere, China’s manufacturing PMI came in slightly above consensus over the weekend, dropping to 50.2 in June from 50.4 in May. Our economics team expects manufacturing activity to gradually recover in the coming months, supported by the government’s ongoing stimulus measures – for this reason we avoid the temptation to get excessively bearish on AUDUSD into year end. Attention now turns to Thursday’s ECB policy decision where a majority of economists expect a 25bp cut to the refi rate even though only 8bp of easing is priced in. If a rate cut is forthcoming, we would expect to see further downward pressure on the euro.
Click here to read the full report: UBS Morning Adviser Asia
UBS Investment Bank